Like many other types of investments, hedge funds have indices that track the industry. There are some differences between hedge fund indices and more traditional investment indices, as hedge funds are considered private investments, and more than that, they are mostly all illiquid. This poses some issues with the reliability indices; how comprehensive, and thus satisfactory, are they, really? This is part of why several different methods of hedge fund indexing have been created over the years.
Regardless of whether or not hedge fund indices are fully satisfactory, there is no question that they exist, and that people use them. There are generally three types of hedge fund indices, and these include:
- Non-investable indices – Using a hedge fund database from which to measure performance, non-investable indices are the oldest type of hedge fund indices used. The databases use weighted mean, medium, and mean in order to measure performance. No one database will represent all funds, which means that no one database is the same as another; every single performance result will be different. This is an issue that some have with the reliability of non-investable indices. Another issue that some have with them is that they are subject to a lot of bias. For one, database reporting is voluntary, which in some cases may lead to self-selection bias. Additionally, hedge funds may come and go (fail and succeed, if you will) annually, which changes the database selection significantly every year.
- Investable indices – the main goal of an investable index is to eradicate some of the bias and issues raised with using a non-investable index. The main method it does this is by making the index return available to all shareholders. In an investable index, the index provider/manager will select certain funds to develop something somewhat like a “fund of hedge funds” portfolio. The investments created by the index provider must be accepted by any hedge funds, in order to be properly investable.
- Hedge fund replication – this is more of a statistical look at how hedge funds have performed, analyzing past returns in order to make models of how hedge funds will perform under various circumstances with different assets. The model(s) can be used to make an actual portfolio of assets, and thus makes the index investable. Of the three types of hedge fund indices mentioned here, hedge fund replication is probably the newest. One of the pitfalls that goes along with this index form being so new is that there is very little history or data to support its usefulness in practice – especially when one considers the private, rarely disclosed nature of hedge funds themselves.
This is essentially the beginning of what hedge fund indices entail. They are meant to give investors – and the financial market as a whole – a view of what average returns on hedge funds are, and how they change throughout time. Even though there is some question as to the reliability of hedge fund indices, given that most of the data found within is self-disclosed and therefore very limited, they are popular and continue to grow.